Keys Corporation's 5-year bonds yield 6.20% and 5-year T-bonds yield 4.40%.The real risk-free rate is r* = 2.5%,the inflation premium for 5-year bonds is IP = 1.50%,the liquidity premium for Keys' bonds is LP = 0.5% versus zero for T-bonds,and the maturity risk premium for all bonds is found with the formula MRP = (t − 1)× 0.1%,where t = number of years to maturity.What is the default risk premium (DRP)on Keys' bonds?

Question

Quizplus · Accepted Answer

First, we need to calculate the total risk premium for Keys' bonds.

Total Risk Premium = IP + LP + MRP= 1.50% + 0.5% + (5-1) x 0.1% = 3.10%

Next, we need to subtract the risk-free rate from the bond yield to get the default risk premium.

DRP = Bond Yield - Risk-free Rate - Total Risk Premium 
DRP = 6.20% - 2.5% - 3.10% = 0.60%

Therefore, the default risk premium on Keys' bonds is 0.60% or 60 basis points.

The best choice is B, which is the answer that gives the correct default risk premium of 1.30%.

Keys Corporation's 5-Year Bonds Yield 6